Why You Should Consider an FHA ARM Loan
Thanks to low down payment and low credit score requirements, mortgages guaranteed by the Federal Housing Administration (FHA) have a reputation of being great options for first-time homebuyers. If you’re considering one, know that there are multiple kinds of FHA mortgages. Depending on your homebuying plans or needs, an FHA-guaranteed adjustable-rate mortgage (ARM) may be the right loan to help you purchase your new house. In this article, we’ll explain FHA adjustable-rate mortgages and when to consider using them.
- What is an FHA adjustable-rate mortgage?
- What are the benefits of an FHA adjustable-rate mortgage?
- What are the disadvantages of an FHA adjustable-rate mortgage?
- When does it makes sense to get an FHA ARM?
- How to find an FHA adjustable-rate mortgage
What is an FHA adjustable-rate mortgage?
Adjustable-rate mortgages are home loans where the interest rate on the mortgage can change as often as once per year. FHA ARMs are adjustable-rate mortgages guaranteed by the Federal Housing Administration. The FHA does not issue FHA mortgages. Instead, the agency insures the mortgages so lenders are protected from loss if these higher-risk borrowers default on the loans.
FHA ARMs share these features:
- Introductory rate period: All FHA-guaranteed ARMs feature an introductory rate period. During the introductory rate period, the interest rate on your mortgage will not change. FHA mortgages offer introductory rate periods of 1, 3, 5, 7 or 10 years. After the introductory period, rates on the FHA mortgage can change as often as once per year. ARMs with introductory rate periods longer than one year are called hybrid mortgages. These loans offer the security of constant payments for several years, but have lower initial interest rates (on average) than fixed-rate mortgages.
- Annual interest rate adjustments: Following the introductory rate period, interest rates on FHA-guaranteed ARMs can change as often as once per year. Your interest rate could go up or down. The adjustment in your interest rate will be based on changes to an underlying interest rate index.
- Constant margin: When your lender initially issues your mortgage, the loan will specify an index plus a margin rate. Together, the index plus the margin equals your total interest rate. While the underlying index on your mortgage might change, the margin will usually not. The margin could decrease during the life of the loan if the loan hits a rate adjustment cap. When that happens, the margin on the loan decreases until the next adjustment.
- Annual and lifetime rate caps: The FHA limits how much your interest rate can adjust each year and over the lifetime of the loan. These adjustment caps protect borrowers from devastating spikes in their monthly payments. These are the adjustment caps on FHA mortgages.
- 1- and 3-year ARMs: 1% increase annually, 5% increase over life of the loan.
- 5-year ARMs: up to 2% increase annually, up to 6% increase over life of loan
- 7- and 10-year ARMs: 2% increase annually, 6% increase over life of loan
- Fully amortizing: All FHA mortgages will be paid off in 30 years or less if you make all the payments as agreed.
- Down payments as low as 3.5%: FHA mortgages allow borrowers to make down payments as low as 3.5%.
- Credit scores as low as 500: Lenders may set their own credit score standards, but the FHA will guarantee loans for borrowers with credit scores as low as 500.
- Loan limits: The FHA limits loan sizes on a county-by-county basis. Throughout most of the country, the maximum you can borrow for a single-family home is $314,827. In high cost of living areas, the loan limit may be as high as $726,525. You can check the FHA limits in your area, using this tool.
What are the benefits of an FHA adjustable-rate mortgage?
Lower interest rates today. Right now, the average interest rate on a 5/1 ARM is 0.35 percentage points lower than the average rate on a 30-year fixed-rate mortgage. The lower interest rates today can help you pay off your mortgage faster or just enjoy a lower payment. However, counting on a low payment is a risky strategy. To mitigate that risk, Arielle Minicozzi, a CFP with Sphynx Financial Planning and former loan officer, told LendingTree that she advises her clients, “To invest the difference in the monthly payment compared to a fixed-rate loan to use as a reserve if rates rise in the future.” Setting aside extra money in the early years of an ARM makes it less likely that you’ll struggle with payment increases down the road.
Lower payments. With lower interest rates come lower payments. Based on today’s rate environment, you’ll save nearly $51 per month on a $250,000 loan when you choose a 5/1 ARM rather than a 30-year fixed mortgage. Of course, this savings is only guaranteed to last for the first five years of the loan.
Some protection from rate increases. Interest rates on FHA ARMs can only increase by 1%-2% each year, and no more than 5%-6% over the life of the loan. These limits insulate borrowers from some of the payment shocks associated with rising interest rates.
Down payments as low as 3.5%. If your credit score is at least 580, you can use the FHA mortgage to buy a house with as little as 3.5% down. You can get a conventional mortgage with as little as at least 3% down, but the credit score requirements are higher.
What are the disadvantages of an FHA adjustable-rate mortgage?
May not qualify for a larger loan based on your income. In some cases, the lower payments on an ARM mean that you can qualify for a larger mortgage today, without increasing your income. But that isn’t always the case. Minicozzi explained, “Lenders do not always use the lower initial payment for qualifying purposes, so an ARM is not a good way to qualify for a higher loan amount.”
Upfront mortgage insurance premiums. One of the biggest pitfalls of the FHA mortgage is the cost of upfront mortgage insurance. When you take out an FHA mortgage, you’ll pay a 1.75% fee to ensure the loan. Conventional loans don’t require any upfront mortgage insurance.
Annual mortgage insurance costs. Every year, you’ll pay a mortgage insurance premium (MIP) on your FHA mortgage. For borrowers with less than 5% down on a 30-year mortgage, the MIP is 0.85%. You have to pay MIP for the life of the loan (unless you put down at least 10%, then you only pay MIP for 11 years). By comparison, conventional mortgage borrowers only pay mortgage insurance until they’ve reached 20% equity in their home.
Possible payment increases. It’s impossible to predict interest rate changes, but if you take out an FHA ARM, you may face payment increases during the life of your loan. This is an important risk to consider if you don’t expect to see dramatic income increases over the next several years.
Lower loan limits (in parts of the country). Compared with conventional mortgage borrowers and VA mortgage borrowers, FHA mortgages often have lower loan limits. Depending on housing prices in your area and your needs, you may not be able to use the FHA ARM to buy the house you want.
When does it make sense to get an FHA ARM?
You have the right buying opportunity. FHA loans tend to be easier to qualify for compared with conventional mortgages. Combine the easier qualifications of an FHA mortgage with the lower payments on ARMs, and you have an ideal loan for someone who wants to flip a house or buy an undervalued home. Ian Bloom, financial adviser and owner of Open World Financial Life Planning in Raleigh, N.C., told LendingTree, “I wouldn’t particularly love a client choosing an ARM right now since the likelihood of interest rates rising in the next few years seems high. But if we combine a unique deal on a property with an FHA ARM, things can work out.” In particular, Bloom emphasized that buyers taking out an FHA ARM should be able to sell their property for a profit before the ARM resets.
You’re expecting dramatic increases in income. The lower rate on an adjustable rate mortgage means that you can qualify for a larger loan on the same income. Yves-Marc Courtines, a CFA with Boundless Advice in Manhattan Beach, Calif., told LendingTree, “I had a client with good income, a job with a nice trajectory who was really looked forward to owning a home in a new development. They were willing to pay the added FHA fees to get into the home.” Before committing to the FHA ARM, ask your lender about the maximum monthly payment that you could face with the loan.
You want to buy with a lower credit score. In general, people with moderate or lower credit scores will save money by choosing an FHA loan rather than a conventional mortgage. Taking out an FHA ARM offers an opportunity to double up on the savings. Not only will you save money by choosing the FHA loan, but you’ll also enjoy a lower initial interest rate by choosing an ARM. In a few years, you may be able to refinance to a conventional loan with a fixed interest rate and no mortgage insurance.
You want to aggressively pay down your mortgage: If you want to pay off your mortgage in 15 years or less, an ARM can help you toward your goal. During the initial rate period, you’ll put more money toward your principal loan balance automatically. The lower rate should give you more room to make extra principal payments. Even better news? Since mortgages are paid on an amortization schedule, making extra principal payments early shortens your loan more than making those extra payments later on.
How to find an FHA adjustable-rate mortgage
If an FHA-guaranteed ARM makes sense for you, it’s important to find the lender that gives you the lowest costs. You can use LendingTree to find and compare FHA mortgage rates from lenders in your area. When you speak to loan officers from each bank, be sure to ask about which adjustable-rate mortgage products the bank offers. If possible, you’ll want to compare rates and fees on multiple ARM products from multiple lenders. By checking rates with multiple lenders, you’re much more likely to get the best possible deal.